Even seasoned emerging-market investors have to draw the line somewhere. And for all but the steeliest, the Ukrainian hryvnia has now crossed to the wrong side of that line—a view reinforced this month by two credit-rating downgrades as the cash-strapped country struggles to secure funding from the International Monetary Fund.

For much of 2012, investors were prepared to give Ukraine the benefit of the doubt, accepting that economic overhauls and an IMF agreement were unlikely before October's parliamentary elections. Cash-rich investors were also prepared to accept riskier bets in their hunt for yield; Ukrainian local-currency Treasury bills yield above 20%.

With a population of 46 million, Ukraine is also one of Europe's sleeping giants.

But with the elections over and little sign of the changes coming, including key sticking points with the IMF such as cuts in costly household gas subsidies and greater currency liberalization, investor goodwill has waned.

After falling for most of the year, the hryvnia has steadied since the start of December. But the tightly managed currency is still more than 1% weaker than where it started 2012, and investors expect its decline to continue in the new year.

“A couple of months ago, just after the elections, we sold all our Ukraine exposure, both sovereign and corporate,” said Viktor Szabo, an emerging-market debt portfolio manager at Aberdeen Asset Management in London, which manages around $9.5 billion in emerging markets debt.

Investors’ concerns intensified earlier this month when both Moody’s Investors Service and Standard & Poor’s Corp. downgraded Ukraine’s credit rating further into junk territory and the IMF decided to delay its visit until January. The reinstatement of Mykola Azarov as prime minister last week is unlikely to bring much relief; Mr. Azarov has been a committed opponent of increasing gas tariffs on households.

The question for investors now is not if the hryvnia will fall, but rather how far and how fast. There are a broad range of estimates; Goldman Sachs expects a devaluation of about 30% by the second quarter of 2013 while Barclays anticipates a one-off 20% move in the second quarter. Forward foreign-exchange markets are pricing in a decline of about 30%.

The hryvnia is pegged to the dollar at an official rate of 7.993 hryvnias. Although it is allowed to veer slightly away from that, the central bank has consistently stepped in to prevent it from sliding sharply.

The currency has come under pressure this year from the country’s widening current-account deficit and from the realization that its debt repayments are set to rise next year. Underscoring the worries, local households and companies have been shifting bank deposits into dollars or moving funds out of the country.

“Financing a current account deficit of $14 billion together with $6 billion in IMF repayments and $2 billion in other sovereign repayments looks extremely problematic,” said Luis Costa, emerging markets strategist at Citigroup Inc. in London.

Investors focusing on the currency are restricted to the dollar-hryvnia non-deliverable forward market, which is settled in cash using the difference between the contracted NDF rate and the prevailing spot rate. But this market is illiquid and has large gaps between where traders want to buy and sell, making it difficult to trade large amounts.

“We choose not to invest in Ukraine because the liquidity is poor for the amounts our clients need to execute in,” said Javier Corominas, head of economic research and currency strategy at London-based Record Currency Management Ltd., which managed $32.5 billion in client currency exposures at the end of September.

Foreign buyers are wary of Ukrainian hryvnia-denominated bonds despite their high yields because of the risk of a large currency devaluation. The implied yields on three-month forward currency contracts stand at about 34% while those on six-month forwards are 30%, above the 24% yields on 2015 bonds.

A deal with the IMF is crucial for an improvement in investor attitudes toward Ukraine. The IMF put a $15 billion loan program on hold in 2011. The country needs to repay $6 billion next year, according to Fitch Ratings.

“Once we see they are seriously engaged with the IMF and there’s a good chance of getting a deal, then you would look to invest,” said Szabo at Aberdeen Asset Management, adding that Ukraine isn’t in a state where investors can be confident it won’t blow up.

Not all investors would wait for an IMF agreement though. Andre Andrijanovs, an analyst at frontier-market investment-banking boutique Exotix Ltd., which specializes in illiquid assets, argued that it might be too late.

“For the deal with the IMF, if it’s making progress next quarter that could be a turning point…There are signs that the market may be overplaying hryvnia devaluation,” he said. For him, a fall of more than 10% is unlikely.

But the illiquidity of the hryvnia NDF market, the gloomy economic outlook and the lingering uncertainty of a deal with the IMF mean that most emerging-market investors will likely continue to steer clear of Ukraine for the foreseeable future.

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